Passive investing is on a tear, and for very good reason

Ever since 1975, when then-CEO John C. Bogle created the first index fund for retail investors at The Vanguard Group, there's been a raging debate about whether active management is worth paying for. Investors seem to have settled that question for themselves.

Just over half of assets in both mutual funds and exchange-traded funds are now passively invested, meaning they follow an index of some sort, according to research firm Morningstar. Over the last year alone some $408 billion has flowed into passively managed funds. Meanwhile, investors have yanked $329 billion out of actively managed funds.

It's not hard to see the appeal of indexing and why more people are becoming convinced of its charms, said Mel Lindauer, co-author of "The Bogleheads' Guide to Investing."

Market Index
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"More and more people are starting to realize that it's a losing proposition," Lindauer said. "Indexing has cleaned the clock of active."

The performance edge

According to the latest S&P Indices Versus Active (SPIVA) Scorecard, a semi-annual report comparing actively managed funds to their benchmarks, just 18 percent of large-cap managers outperformed on a relative basis over a 10-year period, and only 13 percent of mid-cap and 12 percent of small-cap managers managed to do the same.

"Most active management hurts rather than helps investors," said Paul Merriman, a retired financial planner who started the Merriman Financial Education Center to increase financial literacy.

On the portfolio level, indexing is even more powerful, according to the research from Rick Ferri, founder of Portfolio Solutions, a wealth management firm that creates portfolios of index funds, and Alex Benke, vice president of financial advice and planning at Betterment.

Ferri and Benke pitted 5,000 active and index portfolios against each other and concluded that the more index funds a portfolio has, the higher the probability of outperformance. They call it the "passive portfolio multiplier."

"Maybe you picked one of the outperforming funds, but when you start picking two or more, your odds go down," Lindauer said.

Less you pay, the more you keep

The biggest advantage for index funds is cost. Because they simply replicate an index, passive funds don't need to pay as many portfolio managers and analysts. Fund selection is done by algorithm.

"The average cost of an actively managed fund is more than [1 percent], said Fran Kinniry, principal and head of portfolio construction at Vanguard. "What that means is that active management needs to outperform the market by at least that much to outperform at all."

When it comes to investing, cheap is good, said Matt Becker, a fee-only financial planner and founder of Mom and Dad Money, but it's counter to the way consumers usually approach spending. "We're used to paying more for quality," Becker said.

Researcher Morningstar found that expense ratio — not past performance or a manager's ability — was the biggest predictor of future returns.

"What we're trying to do is get the return of an asset class. How do we access an asset as cheaply as possible?" -Paul Merriman, founder of the Merriman Financial Education Center

The average expense ratio of an actively managed fund is 1.2 percent, according to Morningstar; it's about half that, at 67 basis points, for passive managed funds.

Some index funds, such as funds from Vanguard and Fidelity, charge just 5 basis points for investors with at least $10,000. And iShares' ETF version has an expense ratio of just 7 basis points, though you might pay a commission to trade shares depending on your brokerage firm.

In real dollar terms, the math goes like this: Take a $100,000 investment with a 0.9 percent annual expense ratio. After 30 years, the investment will grow to $438,970 — assuming a 6 percent annual return — according to Vanguard. However, with a fund that charges only 25 basis points, that investment will be worth $532,899, almost $100,000 more.

"The longer you're invested, the longer those fees compound and the more it matters," Becker said.

However, indexing doesn't automatically mean low cost. Plenty of index funds charge high fees, particularly if they track indexes in thinly traded markets where they incur high commissions. But that's not the case for 26 S&P 500 funds that have expense ratios of more than 1 percent, according to Morningstar.

"[In that case], I would rather have a low-cost active fund than a high-cost index fund," said Kinniry at Vanguard.


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Easy diversification

Indexing also makes diversification a snap. With just one purchase, investors have access to broad markets, with hundreds, if not thousands, of stocks. "What we're trying to do is get the return of an asset class," explained retired financial planner Merriman. "How do we access an asset as cheaply as possible?"

Diversification is important, he said, because it can keep all your investments from tanking at the same time. A bear market for stocks is often accompanied by the opposite for bonds.

— By Ilana Polyak, special to CNBC.com